Report Concerning Examinations of Options Order Routing and Execution
summary
Between 2005 and 2006, the SEC found that broker-dealers prioritized payment for order flow and internalization over best execution for retail options orders, routing trades to affiliated or higher-paying markets despite better prices available on exchanges like BOX, ISE, and CBOE, leading to artificially wide spreads and prompting a 2007 penny pilot program.
paragraph
From 2005 to 2006, SEC examinations revealed that while smart routing technology improved options order execution, broker-dealers increasingly routed customer orders based on payment for order flow and internalization rather than price quality. Despite the availability of penny pricing and price improvement mechanisms on exchanges like BOX, ISE, and CBOE, most firms avoided them due to informational asymmetries, lack of standardized data, and financial incentives tied to ownership stakes. Quote spreads remained artificially wide due to 5¢ and 10¢ tick sizes, and only one of eight firms conducted comprehensive execution quality reviews, prompting the SEC to launch a January 2007 penny pilot program to enhance competition.
narrative
Between 2005 and 2006, the SEC conducted examinations of eight broker-dealers with significant retail options order flow and found that while smart routing technology had improved execution quality since the 2000 report, payment for order flow and internalization had become more pervasive, overriding better-priced opportunities. Despite the availability of price improvement mechanisms on exchanges such as the Boston Options Exchange (BOX), International Securities Exchange (ISE), and Chicago Board Options Exchange (CBOE), most firms avoided routing orders to these venues due to concerns over transparency, informational asymmetries, and structural incentives tied to ownership stakes and exchange-sponsored payments. Quote spreads remained artificially wide because options prices continued to be quoted in 5¢ and 10¢ increments, limiting competition and allowing excess dealer profits to be shared with order flow providers. Only one of the eight firms examined conducted comprehensive execution quality reviews, highlighting systemic failures in accountability. The SEC noted that unlike equities markets, where payment for order flow declined after the move to penny quoting, options markets had not seen similar reform. The examinations preceded the January 2007 penny pilot program, which aimed to test whether quoting certain options in pennies would improve price competition and execution quality. The findings underscored how financial incentives, not market efficiency, were driving routing decisions, undermining the duty of best execution owed to retail investors.
Classified broker-dealer-fraud(confidence 80%). EDGAR detection: forms Form D· recall 29% / precision 9%. detection rule →
Statutes
17 C.F.R. § 242.605 (2005)
Keywords
orderorder flowoptionsfloworder routingfirmsstaffpayment orderroutingordersstaff foundmarketexecutionexchangeexchanges
Extracted insights
Triples 11
- Staff Conducted Examinations Of Options Order Routing Practices
- Staff Sought To Determine Whether Order Routing Practices Have Changed Since December 2000
- Staff Sought Assistance From The Office Of Economic Analysis
- Staff Found Increased Competition For Options Orders
- Staff Found That The Introduction Of Payments For Order Flow Had An Impact On Order Routing Decisions
- Staff Found That Firms That Accepted Payments For Order Flow Routed Orders To Specialists That Paid For Order Flow More Often Than Firms That Did Not
- Staff Found Inadequacies In The Comparability Of Data
- The Commission Expressed Concern That Payment For Order Flow And Internalization In The Markets Contribute To An Environment In Which Quote Competition Is Not Always Rewarded
- The Staff’s Recent Examinations Revealed Improvement Over The Last Six Years In Order Routing Firms’ Processes To Obtain Best Execution For Their Retail Customers’ Options Orders
- The Staff Found That Many Firms Have Begun To Utilize Order Routing Technology To Ensure That Marketable Retail Customer Options Orders Are Sent To The Market Displaying The Best Price
- The Staff Found That Firms Rely On Other Competitive Factors To Determine To Which Market Center To Route Customer Orders
Text layers
Extracted body text (28,674c)
Report Concerning Examinations of
Options Order Routing and Execution
Office of Compliance Inspections and Examinations
Division of Market Regulation
Office of Economic Analysis
United States Securities and Exchange Commission
March 8, 2007
Report Concerning Examinations of Options Order Routing and Execution
March 8, 2007
I. INTRODUCTION
Staff from the Office of Compliance Inspections and Examinations (“Staff”) conducted a series
of examinations of the options order routing practices of eight broker-dealers that have a
significant amount of retail options order flow.
1
Staff from the Division of Market Regulation
also participated in these examinations. The primary purpose of the examinations was to
determine whether the broker-dealers were fulfilling their duty of best execution in their
handling of customer options orders. The Staff also sought to determine whether order routing
practices have changed since December 2000, when Commission staff completed a series of
examinations and reported results in a public report entitled Payment for Order Flow and
Internalization in the Options Markets (“2000 Staff Report”).
2
Finally, the Staff sought
assistance from the Office of Economic Analysis (“OEA”) to analyze quote competition among
the options markets.
In the 2000 Staff Report, following the listing of many options on more than one market, the
Staff found increased competition for options orders, but also found that the introduction of
payments for order flow (including exchange-sponsored programs), internalization, and other
inducements to firms to route their customer orders to particular markets had an impact on order
routing decisions. In fact, the Staff found that firms that accepted payments for order flow
routed orders to specialists that paid for order flow more often than firms that did not. The Staff
also found inadequacies in the comparability of data that limited the ability of order routing firms
to measure the quality of competing markets. The Commission previously has expressed
concern that payment for order flow and internalization in the markets contribute to an
environment in which quote competition is not always rewarded, thereby discouraging the
display of aggressively priced quotes, and impeding investors’ ability to obtain better prices.
3
II. SUMMARY OF SIGNIFICANT FINDINGS
The Staff’s recent examinations revealed that there has been improvement over the last six years
in order routing firms’ processes to obtain best execution for their retail customers’ options
orders. The Staff found that many firms have begun to utilize order routing technology – often
called “smart routers” – to ensure that marketable retail customer options orders are sent to the
market displaying the best price. Because multiple market centers often display the same best
price, however, the Staff found that firms rely on other competitive factors to determine to which
1
The findings in this report are based on the Staff’s examinations and are not findings of the Commission.
2
“Payment for Order Flow and Internalization in the Options Markets,” Office of Compliance Inspections
and Examinations and the Office of Economic Analysis (December 2000),
available at
http://www.sec.gov/news/studies/ordpay.htm [hereinafter, “2000 Staff Report”]. The 2000 Staff Report
stated that the Staff intended to continue to monitor execution quality and the order routing patterns of
firms that accept payments for order flow.
3
See, e.g., Disclosure of Order Execution and Routing Practices, Securities Exchange Act Release No.
43590 (November 17, 2000),
available at http://www.sec.gov/rules/final/34-43590.htm.
2
market center, among those displaying the best price, to route customer orders.
4
Moreover,
because most options prices continue to be quoted in 5¢ and 10¢ increments, spreads remain
artificially wide and the excess dealer profits often are shared with order flow providers through
payment arrangements. Consequently, factors such as payment for order flow and other
inducements continue to play a substantial role in broker-dealers’ order routing decisions.
Indeed, in the recent examinations the Staff found that payment for order flow and
internalization practices have become more pervasive than they were in 2000, which is in
contrast to the experience in the equities markets, where payment for order flow decreased
substantially following the move to quoting in penny increments. Additionally, although three
exchanges – the Boston Options Exchange (“BOX”), the International Securities Exchange
(“ISE”), and the Chicago Board Options Exchange (“CBOE”) – have improved price
competition by offering opportunities for customer options orders to trade in pennies at prices
better than the displayed national best bid or offer, the “NBBO,” the Staff found that most firms
examined have been unwilling to pursue such better prices for a meaningful amount of order
flow.
These examinations were conducted in late 2005 and early 2006 and preceded the current “penny
pilot” program. The “penny pilot,” which began on January 26, 2007, is a six month pilot
program in which the options exchanges are quoting certain series of 13 options classes in
pennies.
5
III. BACKGROUND
The Staff prepared the 2000 Staff Report concerning payment for order flow and internalization
in the options markets in response to the multiple-listing of options in August 1999. Prior to
August 1999, most listed options traded on only one exchange so brokers had no choice with respect
to where to send customers’ orders. As a result, prior to 1999, inducements such as payment for
order flow and internalization were not relevant to order routing decisions in the options market.
Once multiple listing increased, many options classes, particularly the most actively-traded classes,
traded on all four options exchanges: the American Stock Exchange (“AMEX”), the Chicago
Board Options Exchange (“CBOE”), the Pacific Exchange (“PCX”), and the Philadelphia Stock
Exchange (“PHLX”).
6
Broker-dealers were provided with a choice of where to send customer
options orders and in response, many specialist firms, as well as the exchanges themselves,
introduced payment for order flow programs in an effort to induce order routing broker-dealers
4
OEA analyzed quotation data from July 19, 2005 and March 8, 2006 and determined that, for the 1,000
most active options series (representing 41% and 38%, respectively, of the total options trades for the day),
there were at least four exchanges quoting at the inside over half of the trading day. In addition, OEA
found that the NBBO in these series was at the minimum increment for a significant portion of the trading
day.
5
See http://www.sec.gov/news/press/2007/2007-10.htm.
6
Currently there are six registered options exchanges. In addition to the four mentioned above, the ISE
began trading in June 2000, and the BOX began trading in February 2004. In addition, the PCX is now
known as NYSE Arca, Inc.
3
to send them their retail order flow. Alternatively, broker-dealers would route orders to affiliated
specialists or market makers, which is often referred to as “internalization.” The development of
these practices raised concerns about the execution quality of customer options orders. For these
reasons, in July 2000, the Staff was asked to examine and report on payment for order flow and
internalization practices in the options markets, and evaluate how those practices affected order
routing decisions and the execution quality of customer options orders.
7
The Staff found that
payment for order flow programs (including exchange-sponsored programs), internalization, and
other inducements increased substantially after multiple-listing in August 1999 and impacted
firms’ order routing decisions. Specifically, the Staff found that most of the firms that accepted
payment for order flow began routing customer orders to markets that paid for order flow instead
of routing to markets that did not pay.
Since the 2000 Staff Report, there have been important changes in the options markets, many of
which are discussed in the Commission’s February 2004 concept release.
8
The Options Concept
Release discussed the evolution of the options market, highlighted a number of regulatory
initiatives, and identified several concerns relating to payment for order flow, specialist
guarantees, and internalization practices. The Options Concept Release also requested comment
on whether the Commission should extend the existing rules requiring disclosure of execution
quality in the stock markets to the options market
9
or require the options markets to quote in
penny increments.
IV. RECENT EXAMINATION FINDINGS
In conducting the examinations of the eight broker-dealers, the Staff requested information
related to each firm’s options order routing and execution practices. The Staff requested a
description of the factors the firms consider in determining where to route customer options
orders. The Staff also conducted interviews with each firm’s compliance personnel, employees
responsible for making routing decisions, and members of the firm’s best execution committee.
Summarized below are the Staff’s findings related to: (1) the use of smart routing technology;
(2) the prevalence of payment for order flow and other routing inducements in the options
market; (3) the opportunity to receive price improvement in the options market; and (4) the
“regular and rigorous reviews of execution quality” conducted by these firms.
10
7
See 2000 Staff Report, supra note 2.
8
See Competitive Developments in the Options Markets, Securities Exchange Act Release No. 49175
(February 3, 2004), 69 FR 6124 (February 9, 2004) [hereinafter, “Options Concept Release”].
9
Currently, Rule 605 requires markets for NMS stocks to make publicly available, on a monthly basis,
standardized execution quality statistics categorized by order type, individual security, and order size. 17
C.F.R. § 242.605 (2005). NMS stocks are defined as equity securities for which transaction reports are
collected, processed, and made available pursuant to an effective transaction reporting plan.
10
Broker-dealers are required to conduct such reviews pursuant to their duty to seek best execution of
customers’ orders. Order Execution Obligations, Securities Exchange Act Release No. 37619A
(September 6, 1996), 61 FR 48290 at 48323 (September 12, 1996) [hereinafter, “Order Handling Rules”]
(“In conducting the requisite evaluation of its internal order handling procedures, a broker-dealer must
regularly and rigorously examine execution quality likely to be obtained from the different markets or
market makers trading a security.”)
4
A. Use of Smart Routing Technology
The Staff found that, increasingly, broker-dealers are relying on smart router technology or
intermediaries with smart router technology to route their customer orders to a market displaying
the best price. Smart routers are generally designed to immediately review the displayed price
and size of quotes at all six options exchanges and then route marketable orders to a market
center that is displaying the best price.
11
Because multiple markets are often quoting the same
best price, however, other factors, including order routing inducements, continue to play a
substantial role in order routing decisions.
The Staff found that six of the eight broker-dealers examined utilize smart router technology for
at least a portion of their retail options order flow. At the time of the inspection, two broker-
dealers did not use smart routing technology for their retail order flow, but stated that they were
in the process of incorporating this functionality into their routing systems.
12
The Staff found that some firms with smart router capabilities provided their broker-dealer
customers with the option of selecting their own routing hierarchies when multiple markets were
displaying the NBBO with sufficient size to satisfy the order. Otherwise, the smart router firms
routed orders based upon their own internally-created hierarchy table.
B. Payment for Order Flow and Other Inducements
1. Payment for Order Flow
Over the last several years, all of the options exchanges except the BOX adopted rules
establishing exchange-sponsored payment for order flow programs. Under these programs, the
exchanges impose fees upon their members to fund payment for order flow collectively. Such
exchange fees were designed to require all market makers that trade with customer order flow on
the exchange to contribute to the cost of attracting that order flow. The exchanges collect the
fees and allow the specialist firms to direct payments to order routing firms as they deem
appropriate.
Typically, payments by specialists to broker-dealers for order flow are made pursuant to informal
agreements and are not guaranteed. Although nearly all payment for order flow arrangements
are coordinated through the exchange-sponsored programs, some broker-dealers also pay for
order flow outside of an exchange-sponsored program. They do so because they know that they
will be able to profitably trade with a portion of all incoming orders. For example, three firms
examined act as consolidators, i.e., they receive order flow from other broker-dealers, and pay
the other broker-dealers for their order flow. All three firms have affiliated specialist or market
making operations on the various exchanges. The three firms acknowledged that they use the
11
Smart routers generally route non-marketable orders to the market ranked first in the firm’s hierarchy table.
12
In contrast, the Staff notes that both of these firms already used smart routing for portions of their
institutional customer order flow.
5
funds they receive from the exchange-sponsored programs to make payments to the routing
broker-dealers, and one firm stated that it often pays out more than it receives.
The Staff found that six of the eight firms examined accept payment for order flow in exchange
for routing retail customer orders. While all firms that accept payment stated that the payments
do not improperly influence their order routing decisions, the firms did state that if all things are
equal, they will route orders to the market center that pays the most for order flow. Even firms
that use smart routers are able to factor payment for order flow into their routing decisions. For
example, two firms send significant portions of their order flow to a consolidating broker-dealer
that uses a smart router to send orders to the market center displaying the best price. If multiple
market centers are displaying the best price, the consolidating broker-dealer provides the two
firms with the ability to establish their own routing hierarchy tables, which can take payment for
order flow into account.
2.
Routing to Affiliated Dealers and Ownership Interests in Exchanges
The Staff found that five of the eight firms routed significant order flow to affiliated specialists
or market makers. Routing to an affiliate is an alternative to receiving payment for order flow
and allows the firm to capture the profit a dealer makes on a trade. The Staff also found that
seven of the eight broker-dealers included in these examinations have an ownership interest in
one or more exchanges, and that these ownership interests appear to influence where a firm
routes customer orders.
13
C. Price Improvement Opportunities in the Options Markets
“Price improvement” means obtaining an execution at a price better than the current NBBO.
Currently, there are few opportunities to obtain price improvement on executions of retail-sized
orders in the options markets. According to the broker-dealers we examined, most retail-sized
orders are electronically routed to options exchanges and executed at the NBBO via the options
exchanges’ automatic execution systems.
For most retail-sized orders to receive price improvement, the order must be submitted to a
special electronic mini-auction at one of the three exchanges offering such price improvement.
The BOX, ISE, and the CBOE have developed electronic price improvement mini-auctions
called the Price Improvement Period (“PIP”), Price Improvement Mechanism (“PIM”), and
Automated Improvement Mechanism (“AIM”), respectively. Generally, the PIP, PIM, and AIM
operate as follows: A market participant initiates the price improvement auction, which lasts for
three seconds, by submitting a customer order along with a matching proprietary order priced at
13
In late 2005, the Phlx reported a sharp increase in trading volume after six firms purchased an equity
interest in the exchange. According to news articles, some market participants attributed the growth in
Phlx’s volume to new order flow being routed to the exchange from the six firms that took an ownership
interest.
See Veronica Belitski, Phlx Nipping at Amex’s Heels, Wall Street Letter, Nov. 18, 2005. Each of
the six firms that took an ownership interest in the Phlx received warrants to acquire additional shares of
the Phlx. These warrants were exercisable if the firms met specific performance requirements, which
included routing a certain amount of options volume to the Phlx. On July 18, 2006, the Phlx announced
that all six firms had met their performance requirements and exercised their warrants in full.
6
least a penny better than the NBBO. The auction is electronically announced to the other
participants who may then compete for the customer order by entering orders to match or
improve upon the price of the initial improvement order. At the end of the three second auction,
the customer order is matched to the best priced improvement order with time priority, subject to
certain enumerated exceptions.
14
Most of the broker-dealers examined by the Staff expressed reservations about sending orders to
the price improvement mini-auctions. Most firms did not have a clear understanding of the
mechanics of the price improvement mini-auctions. In addition, most firms expressed
reservations about directing orders to a particular market maker because they felt that the market
maker would gain an informational advantage over the rest of the market. Several firms stated
that they thought that orders should be exposed to the entire market, and that limiting exposure
would reduce market quality in the long run. Two of the firms we examined, however, stated
that they regularly direct orders to the price improvement mini-auctions.
D. “Regular and Rigorous Review”
The duty of best execution requires a broker-dealer to execute customers’ trades at the most
favorable terms reasonably available under the circumstances, i.e., at the best reasonably
available price.
15
To make order routing decisions, broker-dealers must periodically assess the
quality of competing markets to assure that order flow is directed to the markets providing the
most beneficial terms for their customer orders. Broker-dealers must examine their procedures
for seeking to obtain best execution in light of market and technology changes and must take into
account price improvement opportunities.
16
The Staff found that all eight firms examined conduct a periodic review (at least quarterly) in an
effort to evaluate the quality of the executions they have received, and to make going-forward
order routing decisions based on those assessments. However, the Staff found that most firms
engage in reviews that do not allow them to completely assess the quality of executions in
options on each exchange.
Unlike the equity markets, the options markets are not required to make available execution
quality information in a standardized form. Thus, a large part of the firms’ quarterly “regular
and rigorous review” involves the review of the quality of executions that their own orders
14
See Securities Exchange Act Release No. 50819 (Dec. 8, 2004); Securities Exchange Act Release No.
49068 (Jan. 13, 2004); and
Securities Exchange Act Release No. 53222 (Feb. 3, 2006). The Commission
has also approved CBOE’s Simple Action Liaison System (“SAL”), Securities Exchange Release No.
54229 (July 27, 2006), which is a price improvement auction that, once implemented, will not require
exchange members to guarantee the customer order a price better than the NBBO. Instead, SAL will
automatically initiate an auction for orders when the CBOE is at the NBBO. The BOX has proposed a
similar system.
See Securities Exchange Act Release No. 55230 (Feb. 2, 2007) (notice of BOX’s UPIP
system).
15
Regulation NMS Adopting Release, Securities Exchange Act Release No. 51808, 70 FR 37496, at 37537-
37538 (citing Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266 (3d Cir.), cert. denied,
525 U.S. 811 (1988) [hereinafter “Regulation NMS Release”].
16
Regulation NMS Release, 70 FR at 37538; Order Handling Rules, supra note 10.
7
received on each exchange. If a firm does not route customer orders to a particular exchange(s),
that market is not included in the review. Only one firm evaluates execution quality for options
across all exchanges, though it uses only its own executions in the evaluation.
The Staff found that the lack of standardized, widely-available information concerning execution
quality may affect firms’ ability to conduct robust reviews of execution quality.
V. OEA ANALYSIS OF QUOTATION ACTIVITY
As noted above, the order routing firms that accepted payment for order flow stated that if all
things are equal, they will route to the market center that pays the most for order flow. These
firms also stated that generally there are multiple market centers quoting at the NBBO. To
determine the level of quote competition among the options markets, and to determine the extent
to which the spread may be constrained by the minimum increment, the Staff requested
assistance from OEA.
OEA analyzed quotation activity on two sample days (July 19, 2005 and March 8, 2006) in the
1,000 most actively-traded options series. The sample was split into three groups, and statistics
are presented below for the 100 most active series, the next 400 most active series, and the next
500 most active series. These 1,000 series collectively accounted for 41% and 38%,
respectively, of the total number of option trades on the sample days.
OEA analyzed the percentage of the trading day that multiple markets were quoting at the inside
bid or ask.
17
For the top 100 most actively-traded options series, four or more exchanges were
quoting at the inside bid for more than 77% of the trading day on both sample days, and four or
more exchanges were quoting at the inside ask for more than 74% of the trading day on both
sample days. Similarly, for the 1,000 most actively-traded series, three or more exchanges were
quoting at the inside bid for more than 84% of the trading day on March 8, 2006, while three or
more exchanges were quoting at the inside ask for more than 84% of that same trading day.
At Inside Bid
Percent of Day Number of Exchanges are at the Inside Bid
Most Active
Series
1 Exchange at Inside
Bid
2 or More
Exchanges at Bid
3 or More
Exchanges at Bid
4 or More
Exchanges at Bid
7/19/2005 3/8/2006 7/19/2005 3/8/2006 7/19/2005 3/8/2006 7/19/2005 3/8/2006
Top 100 9.2% 11.3% 90.8% 88.7% 84.7% 82.0% 77.4% 77.1%
101-500 15.6% 9.0% 84.4% 91.0% 76.5% 86.6% 68.3% 81.1%
501-1000 15.1% 10.7% 84.9% 89.3% 77.3% 83.3% 68.3% 76.5%
Combined 14.7% 10.0% 85.3% 89.9% 77.7% 84.5% 69.2% 78.4%
17
The percentage was calculated for each options series and was then averaged across series. Options series
were ranked by the number of trades on July 19, 2005 and March 8, 2006, respectively.
8
At Inside Ask
Percent of Day Number of Exchanges are at the Inside Ask
Most Active
Series
1 Exchange at
Inside Ask
2 or More
Exchanges at Ask
3 or More
Exchanges at Ask
4 or More
Exchanges at Ask
7/19/2005 3/8/2006 7/19/2005 3/8/2006 7/19/2005 3/8/2006 7/19/2005 3/8/2006
Top 100 11.6% 11.7% 88.3% 88.3% 81.1% 82.3% 74.3% 78.0%
101-500 19.0% 9.8% 81.0% 90.2% 72.0% 85.7% 63.1% 80.9%
501-1000 17.5% 10.4% 82.5% 89.6% 73.6% 84.3% 64.5% 78.0%
Combined 17.5% 10.3% 82.5% 89.7% 73.7% 84.6% 64.9% 79.2%
OEA also analyzed the percentage of the trading day during which the inside spread was equal to
the minimum quotation increment.
18
The analysis shows that for the top 1,000 most actively-
traded series, the inside spread was at the minimum increment for more than 50% of the trading
day on July 19, 2005 and more than 38% of the trading day on March 8, 2006. Moreover, for the
top 100 most actively-traded series, the inside spread was at the minimum increment for
approximately 73% of the trading day on July 19, 2005 and approximately 54% of the trading
day on March 8, 2006.
Percent of Day the Inside Spread Equals the Minimum Tick, July 19, 2005
Series Priced: Top 100 Top 101-500 Top 501-1000 Combined
Below $3.00
(min=.05)
79.9% (n=81) 58.8% (n=322) 53.8% (n=385) 58.5% (n=788)
$3.00-$5.00
(min=.10)
69.3% (n=7) 47.7% (n=40) 51.6% (n=66) 51.3% (n=113)
Over $5.00
(min=.10)
27.8% (n=12) 15.8% (n=38) 15.7% (n=49) 17.2% (n=99)
Combined 72.9% (n=100) 53.6% (n=400) 49.8% (n=500) 53.6% (n=1000)
Percent of Day the Inside Spread Equals the Minimum Tick, March 8, 2006
Series Priced: Top 100 Top 101-500 Top 501-1000 Combined
Below $3.00
(min=.05)
60.3% (n=85) 44.0% (n=313) 37.4% (n=369) 42.6% (n=767)
$3.00-$5.00
(min=.10)
48.9% (n=5) 39.2% (n=43) 29.8% (n=62) 34.3% (n=110)
Over $5.00
(min=.10)
10.1% (n=10) 12.6% (n=44) 13.7% (n=69) 13.0% (n=123)
Combined 54.7% (n=100) 40.0% (n=400) 33.2% (n=500) 38.1% (n=1000)
18
Id.
9
Thus, OEA concluded that, for the most actively-traded options series, it appears that quotation
spreads may be constrained by the minimum quotation increment.
VI. CONCLUSION
The amount of quote competition in the options markets has increased since 2000. For the most
actively-traded options series, there are at least four exchanges quoting at the NBBO for more
than half of the trading day, and the NBBO is at the minimum increment for a significant portion
of the trading day.
The Staff found that while there has been improvement over the last six years in order routing
firms’ processes to seek and obtain best execution for their retail customers’ options orders,
factors such as payment for order flow and other inducements continue to play a substantial role
in broker-dealers’ order routing decisions.
The Staff also found that because standardized execution quality statistics are not provided by
each of the options exchanges, most firms analyze only the execution quality provided to their
own customer orders. The lack of standardized, widely available execution quality data may
affect thorough best execution reviews by firms.
These findings support the Commission’s efforts to encourage the options markets to quote in
penny increments and support the need for standardized execution quality data in best execution
analyses for the options market.
**********
10OCR text (28,644c · tika · 95% conf)
Report Concerning Examinations of
Options Order Routing and Execution
Office of Compliance Inspections and Examinations
Division of Market Regulation
Office of Economic Analysis
United States Securities and Exchange Commission
March 8, 2007
Report Concerning Examinations of Options Order Routing and Execution
March 8, 2007
I. INTRODUCTION
Staff from the Office of Compliance Inspections and Examinations (“Staff”) conducted a series
of examinations of the options order routing practices of eight broker-dealers that have a
significant amount of retail options order flow.1 Staff from the Division of Market Regulation
also participated in these examinations. The primary purpose of the examinations was to
determine whether the broker-dealers were fulfilling their duty of best execution in their
handling of customer options orders. The Staff also sought to determine whether order routing
practices have changed since December 2000, when Commission staff completed a series of
examinations and reported results in a public report entitled Payment for Order Flow and
Internalization in the Options Markets (“2000 Staff Report”).2 Finally, the Staff sought
assistance from the Office of Economic Analysis (“OEA”) to analyze quote competition among
the options markets.
In the 2000 Staff Report, following the listing of many options on more than one market, the
Staff found increased competition for options orders, but also found that the introduction of
payments for order flow (including exchange-sponsored programs), internalization, and other
inducements to firms to route their customer orders to particular markets had an impact on order
routing decisions. In fact, the Staff found that firms that accepted payments for order flow
routed orders to specialists that paid for order flow more often than firms that did not. The Staff
also found inadequacies in the comparability of data that limited the ability of order routing firms
to measure the quality of competing markets. The Commission previously has expressed
concern that payment for order flow and internalization in the markets contribute to an
environment in which quote competition is not always rewarded, thereby discouraging the
display of aggressively priced quotes, and impeding investors’ ability to obtain better prices.3
II. SUMMARY OF SIGNIFICANT FINDINGS
The Staff’s recent examinations revealed that there has been improvement over the last six years
in order routing firms’ processes to obtain best execution for their retail customers’ options
orders. The Staff found that many firms have begun to utilize order routing technology – often
called “smart routers” – to ensure that marketable retail customer options orders are sent to the
market displaying the best price. Because multiple market centers often display the same best
price, however, the Staff found that firms rely on other competitive factors to determine to which
1 The findings in this report are based on the Staff’s examinations and are not findings of the Commission.
2 “Payment for Order Flow and Internalization in the Options Markets,” Office of Compliance Inspections
and Examinations and the Office of Economic Analysis (December 2000), available at
http://www.sec.gov/news/studies/ordpay.htm [hereinafter, “2000 Staff Report”]. The 2000 Staff Report
stated that the Staff intended to continue to monitor execution quality and the order routing patterns of
firms that accept payments for order flow.
3 See, e.g., Disclosure of Order Execution and Routing Practices, Securities Exchange Act Release No.
43590 (November 17, 2000), available at http://www.sec.gov/rules/final/34-43590.htm.
2
http://www.sec.gov/news/studies/ordpay.htm
http://www.sec.gov/rules/final/34-43590.htm
market center, among those displaying the best price, to route customer orders.4 Moreover,
because most options prices continue to be quoted in 5¢ and 10¢ increments, spreads remain
artificially wide and the excess dealer profits often are shared with order flow providers through
payment arrangements. Consequently, factors such as payment for order flow and other
inducements continue to play a substantial role in broker-dealers’ order routing decisions.
Indeed, in the recent examinations the Staff found that payment for order flow and
internalization practices have become more pervasive than they were in 2000, which is in
contrast to the experience in the equities markets, where payment for order flow decreased
substantially following the move to quoting in penny increments. Additionally, although three
exchanges – the Boston Options Exchange (“BOX”), the International Securities Exchange
(“ISE”), and the Chicago Board Options Exchange (“CBOE”) – have improved price
competition by offering opportunities for customer options orders to trade in pennies at prices
better than the displayed national best bid or offer, the “NBBO,” the Staff found that most firms
examined have been unwilling to pursue such better prices for a meaningful amount of order
flow.
These examinations were conducted in late 2005 and early 2006 and preceded the current “penny
pilot” program. The “penny pilot,” which began on January 26, 2007, is a six month pilot
program in which the options exchanges are quoting certain series of 13 options classes in
pennies.5
III. BACKGROUND
The Staff prepared the 2000 Staff Report concerning payment for order flow and internalization
in the options markets in response to the multiple-listing of options in August 1999. Prior to
August 1999, most listed options traded on only one exchange so brokers had no choice with respect
to where to send customers’ orders. As a result, prior to 1999, inducements such as payment for
order flow and internalization were not relevant to order routing decisions in the options market.
Once multiple listing increased, many options classes, particularly the most actively-traded classes,
traded on all four options exchanges: the American Stock Exchange (“AMEX”), the Chicago
Board Options Exchange (“CBOE”), the Pacific Exchange (“PCX”), and the Philadelphia Stock
Exchange (“PHLX”).6 Broker-dealers were provided with a choice of where to send customer
options orders and in response, many specialist firms, as well as the exchanges themselves,
introduced payment for order flow programs in an effort to induce order routing broker-dealers
4 OEA analyzed quotation data from July 19, 2005 and March 8, 2006 and determined that, for the 1,000
most active options series (representing 41% and 38%, respectively, of the total options trades for the day),
there were at least four exchanges quoting at the inside over half of the trading day. In addition, OEA
found that the NBBO in these series was at the minimum increment for a significant portion of the trading
day.
5 See http://www.sec.gov/news/press/2007/2007-10.htm.
6 Currently there are six registered options exchanges. In addition to the four mentioned above, the ISE
began trading in June 2000, and the BOX began trading in February 2004. In addition, the PCX is now
known as NYSE Arca, Inc.
3
http://www.sec.gov/news/press/2007/2007-10.htm
to send them their retail order flow. Alternatively, broker-dealers would route orders to affiliated
specialists or market makers, which is often referred to as “internalization.” The development of
these practices raised concerns about the execution quality of customer options orders. For these
reasons, in July 2000, the Staff was asked to examine and report on payment for order flow and
internalization practices in the options markets, and evaluate how those practices affected order
routing decisions and the execution quality of customer options orders.7 The Staff found that
payment for order flow programs (including exchange-sponsored programs), internalization, and
other inducements increased substantially after multiple-listing in August 1999 and impacted
firms’ order routing decisions. Specifically, the Staff found that most of the firms that accepted
payment for order flow began routing customer orders to markets that paid for order flow instead
of routing to markets that did not pay.
Since the 2000 Staff Report, there have been important changes in the options markets, many of
which are discussed in the Commission’s February 2004 concept release.8 The Options Concept
Release discussed the evolution of the options market, highlighted a number of regulatory
initiatives, and identified several concerns relating to payment for order flow, specialist
guarantees, and internalization practices. The Options Concept Release also requested comment
on whether the Commission should extend the existing rules requiring disclosure of execution
quality in the stock markets to the options market9 or require the options markets to quote in
penny increments.
IV. RECENT EXAMINATION FINDINGS
In conducting the examinations of the eight broker-dealers, the Staff requested information
related to each firm’s options order routing and execution practices. The Staff requested a
description of the factors the firms consider in determining where to route customer options
orders. The Staff also conducted interviews with each firm’s compliance personnel, employees
responsible for making routing decisions, and members of the firm’s best execution committee.
Summarized below are the Staff’s findings related to: (1) the use of smart routing technology;
(2) the prevalence of payment for order flow and other routing inducements in the options
market; (3) the opportunity to receive price improvement in the options market; and (4) the
“regular and rigorous reviews of execution quality” conducted by these firms.10
7 See 2000 Staff Report, supra note 2.
8 See Competitive Developments in the Options Markets, Securities Exchange Act Release No. 49175
(February 3, 2004), 69 FR 6124 (February 9, 2004) [hereinafter, “Options Concept Release”].
9 Currently, Rule 605 requires markets for NMS stocks to make publicly available, on a monthly basis,
standardized execution quality statistics categorized by order type, individual security, and order size. 17
C.F.R. § 242.605 (2005). NMS stocks are defined as equity securities for which transaction reports are
collected, processed, and made available pursuant to an effective transaction reporting plan.
10 Broker-dealers are required to conduct such reviews pursuant to their duty to seek best execution of
customers’ orders. Order Execution Obligations, Securities Exchange Act Release No. 37619A
(September 6, 1996), 61 FR 48290 at 48323 (September 12, 1996) [hereinafter, “Order Handling Rules”]
(“In conducting the requisite evaluation of its internal order handling procedures, a broker-dealer must
regularly and rigorously examine execution quality likely to be obtained from the different markets or
market makers trading a security.”)
4
A. Use of Smart Routing Technology
The Staff found that, increasingly, broker-dealers are relying on smart router technology or
intermediaries with smart router technology to route their customer orders to a market displaying
the best price. Smart routers are generally designed to immediately review the displayed price
and size of quotes at all six options exchanges and then route marketable orders to a market
center that is displaying the best price.11 Because multiple markets are often quoting the same
best price, however, other factors, including order routing inducements, continue to play a
substantial role in order routing decisions.
The Staff found that six of the eight broker-dealers examined utilize smart router technology for
at least a portion of their retail options order flow. At the time of the inspection, two broker-
dealers did not use smart routing technology for their retail order flow, but stated that they were
in the process of incorporating this functionality into their routing systems.12
The Staff found that some firms with smart router capabilities provided their broker-dealer
customers with the option of selecting their own routing hierarchies when multiple markets were
displaying the NBBO with sufficient size to satisfy the order. Otherwise, the smart router firms
routed orders based upon their own internally-created hierarchy table.
B. Payment for Order Flow and Other Inducements
1. Payment for Order Flow
Over the last several years, all of the options exchanges except the BOX adopted rules
establishing exchange-sponsored payment for order flow programs. Under these programs, the
exchanges impose fees upon their members to fund payment for order flow collectively. Such
exchange fees were designed to require all market makers that trade with customer order flow on
the exchange to contribute to the cost of attracting that order flow. The exchanges collect the
fees and allow the specialist firms to direct payments to order routing firms as they deem
appropriate.
Typically, payments by specialists to broker-dealers for order flow are made pursuant to informal
agreements and are not guaranteed. Although nearly all payment for order flow arrangements
are coordinated through the exchange-sponsored programs, some broker-dealers also pay for
order flow outside of an exchange-sponsored program. They do so because they know that they
will be able to profitably trade with a portion of all incoming orders. For example, three firms
examined act as consolidators, i.e., they receive order flow from other broker-dealers, and pay
the other broker-dealers for their order flow. All three firms have affiliated specialist or market
making operations on the various exchanges. The three firms acknowledged that they use the
11 Smart routers generally route non-marketable orders to the market ranked first in the firm’s hierarchy table.
12 In contrast, the Staff notes that both of these firms already used smart routing for portions of their
institutional customer order flow.
5
funds they receive from the exchange-sponsored programs to make payments to the routing
broker-dealers, and one firm stated that it often pays out more than it receives.
The Staff found that six of the eight firms examined accept payment for order flow in exchange
for routing retail customer orders. While all firms that accept payment stated that the payments
do not improperly influence their order routing decisions, the firms did state that if all things are
equal, they will route orders to the market center that pays the most for order flow. Even firms
that use smart routers are able to factor payment for order flow into their routing decisions. For
example, two firms send significant portions of their order flow to a consolidating broker-dealer
that uses a smart router to send orders to the market center displaying the best price. If multiple
market centers are displaying the best price, the consolidating broker-dealer provides the two
firms with the ability to establish their own routing hierarchy tables, which can take payment for
order flow into account.
2. Routing to Affiliated Dealers and Ownership Interests in Exchanges
The Staff found that five of the eight firms routed significant order flow to affiliated specialists
or market makers. Routing to an affiliate is an alternative to receiving payment for order flow
and allows the firm to capture the profit a dealer makes on a trade. The Staff also found that
seven of the eight broker-dealers included in these examinations have an ownership interest in
one or more exchanges, and that these ownership interests appear to influence where a firm
routes customer orders.13
C. Price Improvement Opportunities in the Options Markets
“Price improvement” means obtaining an execution at a price better than the current NBBO.
Currently, there are few opportunities to obtain price improvement on executions of retail-sized
orders in the options markets. According to the broker-dealers we examined, most retail-sized
orders are electronically routed to options exchanges and executed at the NBBO via the options
exchanges’ automatic execution systems.
For most retail-sized orders to receive price improvement, the order must be submitted to a
special electronic mini-auction at one of the three exchanges offering such price improvement.
The BOX, ISE, and the CBOE have developed electronic price improvement mini-auctions
called the Price Improvement Period (“PIP”), Price Improvement Mechanism (“PIM”), and
Automated Improvement Mechanism (“AIM”), respectively. Generally, the PIP, PIM, and AIM
operate as follows: A market participant initiates the price improvement auction, which lasts for
three seconds, by submitting a customer order along with a matching proprietary order priced at
13 In late 2005, the Phlx reported a sharp increase in trading volume after six firms purchased an equity
interest in the exchange. According to news articles, some market participants attributed the growth in
Phlx’s volume to new order flow being routed to the exchange from the six firms that took an ownership
interest. See Veronica Belitski, Phlx Nipping at Amex’s Heels, Wall Street Letter, Nov. 18, 2005. Each of
the six firms that took an ownership interest in the Phlx received warrants to acquire additional shares of
the Phlx. These warrants were exercisable if the firms met specific performance requirements, which
included routing a certain amount of options volume to the Phlx. On July 18, 2006, the Phlx announced
that all six firms had met their performance requirements and exercised their warrants in full.
6
least a penny better than the NBBO. The auction is electronically announced to the other
participants who may then compete for the customer order by entering orders to match or
improve upon the price of the initial improvement order. At the end of the three second auction,
the customer order is matched to the best priced improvement order with time priority, subject to
certain enumerated exceptions.14
Most of the broker-dealers examined by the Staff expressed reservations about sending orders to
the price improvement mini-auctions. Most firms did not have a clear understanding of the
mechanics of the price improvement mini-auctions. In addition, most firms expressed
reservations about directing orders to a particular market maker because they felt that the market
maker would gain an informational advantage over the rest of the market. Several firms stated
that they thought that orders should be exposed to the entire market, and that limiting exposure
would reduce market quality in the long run. Two of the firms we examined, however, stated
that they regularly direct orders to the price improvement mini-auctions.
D. “Regular and Rigorous Review”
The duty of best execution requires a broker-dealer to execute customers’ trades at the most
favorable terms reasonably available under the circumstances, i.e., at the best reasonably
available price.15 To make order routing decisions, broker-dealers must periodically assess the
quality of competing markets to assure that order flow is directed to the markets providing the
most beneficial terms for their customer orders. Broker-dealers must examine their procedures
for seeking to obtain best execution in light of market and technology changes and must take into
account price improvement opportunities. 16
The Staff found that all eight firms examined conduct a periodic review (at least quarterly) in an
effort to evaluate the quality of the executions they have received, and to make going-forward
order routing decisions based on those assessments. However, the Staff found that most firms
engage in reviews that do not allow them to completely assess the quality of executions in
options on each exchange.
Unlike the equity markets, the options markets are not required to make available execution
quality information in a standardized form. Thus, a large part of the firms’ quarterly “regular
and rigorous review” involves the review of the quality of executions that their own orders
14 See Securities Exchange Act Release No. 50819 (Dec. 8, 2004); Securities Exchange Act Release No.
49068 (Jan. 13, 2004); and Securities Exchange Act Release No. 53222 (Feb. 3, 2006). The Commission
has also approved CBOE’s Simple Action Liaison System (“SAL”), Securities Exchange Release No.
54229 (July 27, 2006), which is a price improvement auction that, once implemented, will not require
exchange members to guarantee the customer order a price better than the NBBO. Instead, SAL will
automatically initiate an auction for orders when the CBOE is at the NBBO. The BOX has proposed a
similar system. See Securities Exchange Act Release No. 55230 (Feb. 2, 2007) (notice of BOX’s UPIP
system).
15 Regulation NMS Adopting Release, Securities Exchange Act Release No. 51808, 70 FR 37496, at 37537-
37538 (citing Newton v. Merrill, Lynch, Pierce, Fenner & Smith, Inc., 135 F.3d 266 (3d Cir.), cert. denied,
525 U.S. 811 (1988) [hereinafter “Regulation NMS Release”].
16 Regulation NMS Release, 70 FR at 37538; Order Handling Rules, supra note 10.
7
received on each exchange. If a firm does not route customer orders to a particular exchange(s),
that market is not included in the review. Only one firm evaluates execution quality for options
across all exchanges, though it uses only its own executions in the evaluation.
The Staff found that the lack of standardized, widely-available information concerning execution
quality may affect firms’ ability to conduct robust reviews of execution quality.
V. OEA ANALYSIS OF QUOTATION ACTIVITY
As noted above, the order routing firms that accepted payment for order flow stated that if all
things are equal, they will route to the market center that pays the most for order flow. These
firms also stated that generally there are multiple market centers quoting at the NBBO. To
determine the level of quote competition among the options markets, and to determine the extent
to which the spread may be constrained by the minimum increment, the Staff requested
assistance from OEA.
OEA analyzed quotation activity on two sample days (July 19, 2005 and March 8, 2006) in the
1,000 most actively-traded options series. The sample was split into three groups, and statistics
are presented below for the 100 most active series, the next 400 most active series, and the next
500 most active series. These 1,000 series collectively accounted for 41% and 38%,
respectively, of the total number of option trades on the sample days.
OEA analyzed the percentage of the trading day that multiple markets were quoting at the inside
bid or ask.17 For the top 100 most actively-traded options series, four or more exchanges were
quoting at the inside bid for more than 77% of the trading day on both sample days, and four or
more exchanges were quoting at the inside ask for more than 74% of the trading day on both
sample days. Similarly, for the 1,000 most actively-traded series, three or more exchanges were
quoting at the inside bid for more than 84% of the trading day on March 8, 2006, while three or
more exchanges were quoting at the inside ask for more than 84% of that same trading day.
At Inside Bid
Percent of Day Number of Exchanges are at the Inside Bid
Most Active
Series
1 Exchange at Inside
Bid
2 or More
Exchanges at Bid
3 or More
Exchanges at Bid
4 or More
Exchanges at Bid
7/19/2005 3/8/2006 7/19/2005 3/8/2006 7/19/2005 3/8/2006 7/19/2005 3/8/2006
Top 100 9.2% 11.3% 90.8% 88.7% 84.7% 82.0% 77.4% 77.1%
101-500 15.6% 9.0% 84.4% 91.0% 76.5% 86.6% 68.3% 81.1%
501-1000 15.1% 10.7% 84.9% 89.3% 77.3% 83.3% 68.3% 76.5%
Combined 14.7% 10.0% 85.3% 89.9% 77.7% 84.5% 69.2% 78.4%
17 The percentage was calculated for each options series and was then averaged across series. Options series
were ranked by the number of trades on July 19, 2005 and March 8, 2006, respectively.
8
At Inside Ask
Percent of Day Number of Exchanges are at the Inside Ask
Most Active
Series
1 Exchange at
Inside Ask
2 or More
Exchanges at Ask
3 or More
Exchanges at Ask
4 or More
Exchanges at Ask
7/19/2005 3/8/2006 7/19/2005 3/8/2006 7/19/2005 3/8/2006 7/19/2005 3/8/2006
Top 100 11.6% 11.7% 88.3% 88.3% 81.1% 82.3% 74.3% 78.0%
101-500 19.0% 9.8% 81.0% 90.2% 72.0% 85.7% 63.1% 80.9%
501-1000 17.5% 10.4% 82.5% 89.6% 73.6% 84.3% 64.5% 78.0%
Combined 17.5% 10.3% 82.5% 89.7% 73.7% 84.6% 64.9% 79.2%
OEA also analyzed the percentage of the trading day during which the inside spread was equal to
the minimum quotation increment.18 The analysis shows that for the top 1,000 most actively-
traded series, the inside spread was at the minimum increment for more than 50% of the trading
day on July 19, 2005 and more than 38% of the trading day on March 8, 2006. Moreover, for the
top 100 most actively-traded series, the inside spread was at the minimum increment for
approximately 73% of the trading day on July 19, 2005 and approximately 54% of the trading
day on March 8, 2006.
Percent of Day the Inside Spread Equals the Minimum Tick, July 19, 2005
Series Priced: Top 100 Top 101-500 Top 501-1000 Combined
Below $3.00
(min=.05) 79.9% (n=81) 58.8% (n=322) 53.8% (n=385) 58.5% (n=788)
$3.00-$5.00
(min=.10) 69.3% (n=7) 47.7% (n=40) 51.6% (n=66) 51.3% (n=113)
Over $5.00
(min=.10) 27.8% (n=12) 15.8% (n=38) 15.7% (n=49) 17.2% (n=99)
Combined 72.9% (n=100) 53.6% (n=400) 49.8% (n=500) 53.6% (n=1000)
Percent of Day the Inside Spread Equals the Minimum Tick, March 8, 2006
Series Priced: Top 100 Top 101-500 Top 501-1000 Combined
Below $3.00
(min=.05) 60.3% (n=85) 44.0% (n=313) 37.4% (n=369) 42.6% (n=767)
$3.00-$5.00
(min=.10) 48.9% (n=5) 39.2% (n=43) 29.8% (n=62) 34.3% (n=110)
Over $5.00
(min=.10) 10.1% (n=10) 12.6% (n=44) 13.7% (n=69) 13.0% (n=123)
Combined 54.7% (n=100) 40.0% (n=400) 33.2% (n=500) 38.1% (n=1000)
18 Id.
9
Thus, OEA concluded that, for the most actively-traded options series, it appears that quotation
spreads may be constrained by the minimum quotation increment.
VI. CONCLUSION
The amount of quote competition in the options markets has increased since 2000. For the most
actively-traded options series, there are at least four exchanges quoting at the NBBO for more
than half of the trading day, and the NBBO is at the minimum increment for a significant portion
of the trading day.
The Staff found that while there has been improvement over the last six years in order routing
firms’ processes to seek and obtain best execution for their retail customers’ options orders,
factors such as payment for order flow and other inducements continue to play a substantial role
in broker-dealers’ order routing decisions.
The Staff also found that because standardized execution quality statistics are not provided by
each of the options exchanges, most firms analyze only the execution quality provided to their
own customer orders. The lack of standardized, widely available execution quality data may
affect thorough best execution reviews by firms.
These findings support the Commission’s efforts to encourage the options markets to quote in
penny increments and support the need for standardized execution quality data in best execution
analyses for the options market.
**********
10
I. INTRODUCTION
II. SUMMARY OF SIGNIFICANT FINDINGS
III. BACKGROUND
IV. RECENT EXAMINATION FINDINGS
A. Use of Smart Routing Technology
B. Payment for Order Flow and Other Inducements
1. Payment for Order Flow
2. Routing to Affiliated Dealers and Ownership Interests in Exchanges
C. Price Improvement Opportunities in the Options Markets
D. “Regular and Rigorous Review”
V. OEA ANALYSIS OF QUOTATION ACTIVITY
VI. CONCLUSION